Interest Rates Are Already Higher Than You Think

Surprise! Short-term interest rates are higher today than at any time over the past 12 years.

You may have to read that twice.

That’s because the almost universally held belief these days is that, even in the wake of the Federal Reserve’s rate hikes over the past couple of years, interest rates remain extremely low relative to almost any historical standard.

But, as Humphrey Neill, the father of contrarian analysis, famously put it: “When everyone thinks alike, everyone is likely to be wrong.”

To be sure, there certainly appears to be strong historical support for the conventional wisdom on interest rates. The Federal Reserve in December hiked the federal-funds rate to 2.25%-2.5%, and the market expects the Fed to raise the high end of the range to 3% by the end of 2019—though not at this week’s meeting. Nevertheless, it is still well below the 4.8% average for this rate over the last seven decades.

Focusing this way on nominal interest rates is misleading, however, according to a new paper being circulated by the National Bureau of Economic Research (NBER), a research group based in Cambridge, Mass. The paper, entitled “Are Interest Rates Really Low?”, was written by Ivo Welch, chair of the finance department at the UCLA Anderson School of Management; Clinton Tepper, a Ph.D. candidate at that institution; and Daniel Feenberg, a research associate at NBER.

Specifically, the researchers focus on real, or inflation-adjusted, interest rates from the perspective of a taxpaying investor. From that perspective, they calculate that rates in recent years have not been “unusually low.”

Take the one-year Treasury yield, which is currently 2.6%. That falls to 1.9% on an after-tax basis, assuming an effective tax rate that the researchers calculate based on a complex theoretical model that reflects that some bondholders pay no tax, some pay the highest marginal income-tax rate of 37%, and so on. Given that the consumer-price index is also running at a 1.9% pace, the one-year Treasury therefore has an after-tax real yield close to zero.

That seems low only if we don’t do this same calculation historically. In fact, the researchers calculate, the current after-tax real yield on the one-year Treasury is quite close to the historical average back to 1950, nearly 70 years ago—and higher than at any time since mid-2007.

Note that this isn’t simply a function of the Fed’s hiking of the federal-funds rate over the past couple of years. Even before the rate-hike cycle began, short-term rates were already higher than they had been in a decade on an after-tax real basis.

A similar conclusion is reached when we focus on longer-term Treasury yields. The 20-year Treasury’s after-tax real yield is currently 0.2%, for example, and while that is lower than where it stood during much of the 1980s and 1990s, it is higher than it was during much of the 1950s and 1960s.

What about the investment implications? Perhaps the most significant: Since current rates aren’t particularly low, one could make an historically-based argument that, on an after-tax real yield basis, they deserve to fall as much as they do to rise.

That doesn’t mean that nominal rates won’t rise from here. But most likely that would occur in conjunction with an increase in inflation, leaving real yields more or less where they are today.

That’s a good segue into a broader implication of this research: the importance of analyzing historical data in inflation-adjusted terms. By focusing on nominal rates, for example, many will consider the current interest-rate environment to be dramatically different than it was, say, in the late 1970s and early 1980s, when longer-term Treasury yields rose into double-digit territory. But that appearance is a symptom of what economists call “money illusion,” in which we mistake a nominal rate for a real rate. On an after-tax real basis, believe it or not, 20-year Treasury yields today are actually higher than where they stood in 1979 and 1980.

Yet another, perhaps less obvious, implication is that it’s also important to take taxes into account when drawing historical parallels. You might think otherwise, since many bonds are held by tax-exempt institutions or in tax-deferred retirement accounts. But surely bond yields’ should reflect the taxes that at least some bondholders must pay. If you have any doubt that taxes affect security prices, just recall the stock market’s reaction in 2018 to the tax cuts that became law at the end of 2017.

A failure to adjust for taxes is likely to lead you into drawing incorrect inferences about how current interest rates compare to historical norms.

Ask your adviser about this new research the next time you hear him or her allege that interest rates inevitably must rise from their current abnormally low levels. If he or she continues to insist that current rates are abnormally low, you might consider hiring someone else.

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